Capturing Opportunities Created By An Inefficient Market

Municipal Bonds

The Municipal Bond Market is an inefficient market. Professional money managers develop strategies to add value for their clients by taking advantage of some of these inefficiencies. Let's take a look at some of the possible ways these firms seek to increase their clients' returns with their approach to managing funds.

Inefficiencies

The Muni Market is inefficient in some of these ways:
· Smaller blocks trade cheaper than larger blocks.
· Premium bonds often trade cheaper than par bonds.
· Transaction costs are exorbitant for individuals when dealing with a brokerage firm. SEC and Journal of Fixed Income studies show the bid/ask spreads to be between 2%-2.5% for smaller pieces of Munis. These costs are significantly lower for institutions.
· Taxable munis are inherently better credits than corporate bonds, but trade cheaper than they should. For example, a AAA-rated taxable muni trades at about the same spread vs. treasuries as an A-rated corporate bond.
· There are different levels of access to new negotiated deals. For example, an institutional client has access to new deals from the manager of the issue, but competing dealers do not have access to these deals.
· Muni bonds are a legalized way around the wash-sale rule which creates a 30 day waiting period before buying back the same security.
· Shorter munis trade at lower ratios to treasuries than do longer maturities.

Strategies For Adding Value In An Inefficient Market

Strategy 1
Most Separate Account Managers consider an account to be properly diversified when they have 8-20 different holdings. A $1 million account would need block size of $50,000-$100,000 to be properly diversified. Since smaller lot size blocks of munis trade cheaper than larger lots, one possible strategy would be to buy smaller lots of bonds that fit the needs of this client. Most fixed income money managers prefer to purchase larger blocks of bonds ($1 million+) and allocate them to different accounts. The money manager that buys the smaller lots is able to generate better returns for the client because the securities are being purchased at cheaper prices.

Strategy 2
Muni bonds are primarily issued to fund long-term projects such as schools, hospitals, water, and sewers. Deals come to market with maturities from 1-30 years to fund these projects. However, there is an enormous demand in short-term munis due to tax-free money market accounts. This creates a supply/demand imbalance in the marketplace. This imbalance leads to a difference in the ratio of muni yields vs treasury yields between short maturities and long maturities. For example, today the ratio in 1 year is about 70% while it is about 89% in 30 years. In addition, the Muni Market almost always has an upward sloping yield curve. One way to take advantage of this imbalance is to "borrow short and invest long" on the yield curve. This strategy is employed by Tender Option Bond Programs (TOB's) and closed-end tax-free funds. These strategies are usually highly leveraged and are done in large size.

Conclusion

Each investor should have a strategy for his/her portfolio. Does your strategy include some way of capturing opportunities that have been created by ineffecient markets?